With today's record low interest rates, investors looking for dividend yield are forced to look at equities, regardless of their risk profile. This leaves investors looking for strategies that reduce risk and improve yield. Many investors have attempted to trade in and out of stocks before and after a stock's ex-dividend date, only to see their trades end in a loss or less-than-stellar profit. The answer to all these investment problems may be ex-dividend trades paired with covered calls.
Trading ex-dividend to capture yield is made tricky by the practice of market makers to reduce a stock's price on the ex-dividend date. For instance, on August 7, 2012, Wells Fargo & Company (WFC) stock closed the day at $33.96. The next day, the stock traded ex-dividend, with a $0.22 per share dividend awarded to those shareholders who owned shares at the open. At the same time, the stock opened down $0.33. Part of the stock's drop in price was the ex-dividend adjustment. The rest of the change was due to after-hours and pre-market trading. Anyone who bought the day before the dividend was awarded would have been disappointed.
However, there is a solution to this downward price adjustment. Covered call trades limit downside losses by capturing the premium of a call option as income. If the stock price drops, this strategy provides a hedge against losses.
This week, several stocks go ex-dividend with annualized dividend yields that are significantly higher than low-risk bond alternatives and options trading around the underlying equity.
QR Energy, LP (QRE) goes ex-dividend on October 25. The 49 cent dividend gives the stock an annualized yield of over 9%. The November 2012 $20 strike price call option trades with a bid price around $0.65. So, selling the $20 call option would help provide downside protection for when the stock goes ex-dividend. Selling a covered call and collecting the dividend should yield an investor a 2.1% profit for holding the stock for 27 days, or an annualized return of 27.8%. If the stock falls below $19.58, the trade loses money. If the shares are called before the ex-dividend date, then the investor will lose their commissions paid, but little else.
HSBC Holdings PLC (HBC) goes ex-dividend on October 24. The 45 cent quarterly dividend gives the investor an annualized yield of over 3%. Marry the dividend income with a covered call, and portfolio income could be boosted to 2.5% over the next 27 days, or an annualized 32.88%. Again, there is a risk that the shares are called early and the break-even price on the trade is $47.81.
Susquehanna Bancshares, Inc. (SUSQ) will pay a modest 7 cent per share dividend to shareholders of record on October 26 (the ex-dividend date). A covered call with a November 2012 expiration could lock in the dividend and possibly generate some extra income, boosting the profit to 1.5% over the next 27 days, an annualized 20.16%. This in-the-money call could be exercised early, canceling the trade, and the break-even on the trade is $9.85 per share.
The Bank of New York Mellon Corporation (BK) investors could consider selling the $24 November 2012 strike price call option. Collecting the 13 cent quarterly dividend, as well as the 24 cent time value of the option, boosts portfolio income and creates a possible 1.4% profit over 27 days. The break-even on the trade is $23.97.
Covered call calculations were provided by the Options Industry Council for hypothetical purposes. Do your own due diligence before investing.